Be Prepared for Audit
If you are audited by the IRS, it will help if you keep organized records. The purpose of any audit is to verify records. Taxpayers are required by law to maintain and keep books and records sufficient to establish the items of income, deductions or credit reported on the tax return. These records may consist of (1) primary records, including invoices, vouchers, bills, receipts and canceled checks; and (2) secondary records, such as your permanent books and records
The first step in winning an audit attack is to present proof of your income and deductions in an organized way that will satisfy the Revenue Agent. If you have asked for sufficient time to prepare your records, you will be able to compile your documents to support most requests by the IRS.
Usually upon receipt of a notice for audit, the IRS includes a list of items that it would like you to verify. After the initial audit meeting, it is likely that you will receive a document production or information request that lists additional information needed. Failure to provide adequate records is the #1 reason for disallowance of a deduction.
The Black Book Approach
At this juncture, it is time to compile a “black book.” Such a book is invaluable because it indexes each document request and is a wonderful organization tool. You should make copies of the relevant data to support each request and include it in the black book. If information is not available or the request is unreasonable, you should explain this in a simple statement.
Wherever appropriate, include taxpayer statements or narratives. You should also include schedules, amendments to the tax returns (if errors are found) or other relevant information. Be sure and make copies of all the items to be submitted so you can have a record of all the documents examined in the audit. This is especially useful in complex cases. If there are 10 document requests and accordingly, for example, 10 black books should be compiled, all indexed for submission.
The important point about the black book is that the Revenue Agent knows you are prepared to appeal the case if necessary and that you or your attorney will not have to undergo additional factual development or legal analysis. All the homework has been done in advance. The Revenue Agent is also aware that on appeal, additional evidence and the hazards of litigation will be considered in reaching a settlement. The taxpayer’s case is complete and ready to go to appeals.
Taxpayers always have the right to appeal. If the Revenue Agent is not satisfied with your “proof” for a certain deduction, for instance, you can still show proof in Tax Court in the form of canceled checks, logs, receipts, bank statements, or testimony. Do not be intimidated into concession if the Revenue Agent claims your proof is not sufficient. It may be sufficient upon appeal. Usually, the Revenue Agent will not accept taxpayer testimony as verification, but upon appeal the IRS will consider this evidence. Remember, the Revenue Agent’s report is not the final word.
Record Keeping Affects Burden of Proof
Recently, there was a case where the Judge in Tax Court ruled against Jane Doe because she had not provided complete records in an audit. During an examination, the IRS claimed she owed an additional $35,000 of taxes. The Revenue Agent had disallowed many of her business expenses on her Schedule C Sole proprietorship chiropractic business. The IRS claimed she had not adequately documented her expenses. Jane thought she should appeal the auditor’s findings to the U.S. Tax Court. She felt that she did not need legal representation. After all, she believed that the IRS had the burden to prove her expenses were overstated.
She went to Tax Court and the Judge told her that he needed to determine whether she or the government held the burden of proof. The Judge instructed her that normally she would bear not the burden of proof if she could prove that she had cooperated fully in the audit. Because she had not presented complete books and records at the time of the audit, the Judge ruled that she had the burden of the proof.
If you do not maintain adequate books and records, the IRS may issue a Notice of Inadequate Books and Records. If you receive this notice you will be subject to audit for the following three years so that the IRS can ascertain whether you are complying with the Internal Revenue Code requirements. This can be costly in time and expense.
Often clients want to know why the Revenue Agent keeps asking for certain information. People feel harassed, but usually the requests are normal and the Revenue Agent is merely following audit guidelines. Remember that the Revenue Agent’s job is to identify items for adjustment, verify items on your tax return, and ascertain whether the positions taken on your tax return are in compliance with the Internal Revenue Code. Substantiation and verification are the purpose of the IRS audit meeting.